With all the talk in the Business pages lately about reforming deposit insurance by limiting insured deposits to a lesser amount, it is surprising that few have mentioned the most serious flaw: the fixed-rate premium.
Under current rules, a bank pays a fixed percentage of deposits for insurance, despite the amount of risk that it takes on its loans. Managers knowing that depositors' funds are secure might have a tendency to engage in riskier loans to gain a higher return. The same hazard may be present on the depositors' end as well. Since depositors know that their funds are guaranteed, they may have less incentive to withdraw their money and put it in a well-run bank.
The proposal to eliminate deposit insurance altogether would cause extreme protests from a sizable portion of the population. So the next best idea would be to base the insurance premium on the riskiness of the bank's portfolio or on their market-value capital ratios.
This would spur bank managers to find the most favorable risk-return trade-off for the institution. It would also benefit the Federal Deposit Insurance Corp., which would collect more money from banks with high-risk loan portfolios, which have more chance of failing.